Saturday 5 April 2014

When the threads in the safety net break

It's the end of my financial year and time to survey the wreckage. I have lost 6.4% while the FTSE made 7.1% and the Dow 12.7%. It could have been worse, at the end of October my losses were running at -11.2%. So between October and March I managed to make almost 5%. This was while the FTSE lost 1.5%. Message to self - you can do it when you try.

My average return, since I started trading in September 1998, is still almost 14% per year compared with the market's 3.7%. Things began to go wrong in 2009. From that year onwards I have underperformed the market every other year. Previously I outperformed the market in 9 out of 10 years.

I attribute my problems to misreading the market following the 2007/8 crash. I worked on the belief that the chickens created by the wholesale printing of money through QE, the massive government deficits run up in the USA and other wealthy economies, together with the problems faced by weak economies prematurely joining the Euro would come home to roost far sooner than they have. Governments have done a fabulous job of staving off the evil hour. (But read on to the end of this post for some chilling analysis of the global economy.)

Above all I failed to see that developing economies would fund the profligate governments of the developed world and that their cash transfers would result in grossly inflated stock markets. The result was that I was far too cautious in my investing and I was permanently on the wrong side of the market. Incredulously I watched the market rise while sitting on the sidelines. Then I would jump in too late and I would take a hit as the market pulled back.

I hope I have learned my lesson and I will now be able to make the most of whatever next year brings.

That's the past. I start the new year with a clean sheet. No accumulated profits no accumulated losses. It's up to me to make the best of what the market throws at me.

The condition of the market.

After my days of nervous waiting the market has finally pulled back sharply. At the same time gold rallied after its weeks of weakness. Interestingly no-one has stepped up to explain what is happening. Commentary focuses on  the fact that it is mostly momentum stocks, particularly those in biotech and technology that have led the losses. 

Friday's decline followed an initial rally responding to good employment figures. 

Is this the moment I have been waiting for? Too early to say. But here I sit, on the sidelines waiting in the hope that the market will do a big dive so I can pick up some bargains and start to return to my performances of old.


The Dollar Trap by Edwar S. Prasad

I continue to read the Dollar Trap. The chapter I have just completed analyses the phenomenon of currency reserves in developing countries. 

These countries desire to build a buffer that will enable them to weather future storms in international markets. They are willing to buy low yielding bonds  issued by rich countries (essentially the USA) and they see the sacrifice in yield as an insurance premium they have to pay to protect themselves.The bonds they buy are safe assets and as their savings grow their security grows. They plan to buy their way out of any problems by cashing in their accumulated savings. (Savings for a rainy day.)

Luckily for them they achieve a collateral benefit. The positive trade balance of these low cost countries, (especially China), puts upward pressure on the exchange rate of their own currencies. Higher FX rates erode their competitive advantage. The act of buying foreign bonds to augment reserves means that they sell their own currency. This keeps the exchange rate low and maintains the competitiveness of their exports.

There are two disadvantages. First buying low yield bonds has an opportunity cost. If they bought higher yielding assets their savings would generate better income. Some countries tackle this problem by creating sovereign wealth funds that buy better performing assets (e.g. equities, higher yielding bonds etc.) but their priority remains maintaining high levels of safe assets.

The other problem is the risk that, by their sheer volume, safe assets turn into toxic ones. All this security is concentrated in the bonds of one major country: the United States. In the event that all the developing countries need to cash in their securities at once, the effect on the price of US bonds would be catastrophic. Suddenly the security blanket would become a lot thinner. 

Added to this would be the dramatic shift in the supply/demand balance for funds that the US needs to fund its continuing deficit. At present the US finds willing lenders as it borrows more and as it replaces maturing bonds with new ones. In the event of a rush for the exit all that would change. The US would find it difficult to redeem maturing bonds and even to pay interest on existing ones because it would be unable to borrow more money The funding of the US deficit would be shown to have been a Ponzi scheme. 

To be fair, Prasad never says this in so many words, but I find it hard not to draw the conclusion. It has happened before. Investors in the sub prime mortgage  market attempted to protect themselves from disaster by buying swaps to protect their investments. When the mortgage market collapsed AIG, the insurance company that had written the bulk of those swaps almost collapsed and had to be rescued. Without the government's intervention there was a near certainty that  all the institutions that insured their sub prime investments through AIG would have gone to the wall. Who is there to bail out the US treasury if their bonds turn toxic? A chilling thought.





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